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Edited Transcript of GES earnings conference call or presentation 28-Aug-19 8:45pm GMT

Q2 2020 Guess" Inc Earnings Call

LOS ANGELES Sep 6, 2019 (Thomson StreetEvents) -- Edited Transcript of Guess? Inc earnings conference call or presentation Wednesday, August 28, 2019 at 8:45:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Carlos E. Alberini

Guess?, Inc. - CEO & Director

* Sandeep Reddy

Guess?, Inc. - CFO

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Conference Call Participants

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* Dana Lauren Telsey

Telsey Advisory Group LLC - CEO & Chief Research Officer

* Janine M. Stichter

Jefferies LLC, Research Division - Equity Associate

* John David Kernan

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Susan Kay Anderson

B. Riley FBR, Inc., Research Division - Analyst

* Westcott Irvin Rochette

Evercore ISI Institutional Equities, Research Division - Associate

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Guess? Second Quarter Fiscal 2020 Earnings Conference Call. On the call are Carlos Alberini, Chief Executive Officer; and Sandeep Reddy, Chief Financial Officer.

During today's call, the company will be making forward-looking statements, including comments regarding future plans, business and financial opportunities, strategic initiatives, capital allocation and short- and long-term financial outlook. The company's actual results may differ materially from current expectations based on risk factors included in today's press release and the company's quarterly and annual reports filed with the SEC.

Now I will turn the call over to Carlos.

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [2]

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Thank you, operator. Good afternoon, and thank you all for joining us today. I'm very pleased to report our second quarter financial results, which exceeded our expectations in several parts of our business. For the second quarter, we reported another period of solid revenue growth, achieving a 6% increase in revenues and 9% in constant currency. During the period, we increased gross margin by 180 basis points, which was partially offset by a 50 basis point increase in adjusted SG&A expenses, driving an adjusted operating margin increase of 130 basis points to 7% for the quarter. The revenue increase, combined with the expansion in adjusted operating margin, resulted in a 30% increase in adjusted operating profit, which was well ahead of our guidance for the period.

During the quarter, our sales comp performance for our direct consumer businesses, which include stores and e-commerce, were in line with our guidance in all regions; and our wholesale business in North America and in Europe delivered a very strong performance compared to our expectations, even after considering that a portion of the business was positively impacted by early shipments of Fall product.

As we had expected, in Asia, the performance was soft in our 3 major markets: China, Korea and Japan. While the environment remains challenging, we believe that the Guess? brand and our product offering are very relevant to the Asian consumer and that the long-term opportunity in this region remains intact. In the meantime, we will continue to monitor the situation very closely and reassess our investment plans accordingly.

We managed inventories effectively during the period and are well positioned for the Fall and Holiday seasons. We are confident in our business for the second half and have increased our guidance for the full year based on our current trends and forecast. We have successfully mitigated the tariff risk in China through productive negotiations with our vendors, and we expect minimal impact to this year from potential tariff increases. And for next year, we expect to reduce the estimated tariff risk from China production into the U.S. to only 12% of our total apparel production. We are still working on this to further reduce our dependency on China.

I'm also pleased to report that we have made solid progress with our key initiatives since our last earnings call in June. As I mentioned then, we had begun our work on our strategic business plan, and we now expect to share our plan with you at the end of October, during an Analyst Day in New York, when we will have several of our team leaders representing key regions and global functions from across the company. During this webcast event, we will share our key findings and top strategic priorities to take Guess? to the next level of growth and profitability.

During the last few months, we continued to operate the business following the key principles that I have alluded to in our previous calls, to take advantage of value-creation opportunities for our company. Let me begin with an update on capital allocation.

As we reported in our last call, we made a strategic decision to redeploy capital and return incremental value to our shareholders through significant share repurchases, while reducing our dividend by 50%. As of today, we estimate that all of the net proceeds from our convertible debt transaction have been disbursed, and we believe that all-in we will be able to repurchase over 16 million shares, representing approximately 20% of our 81.4 million shares outstanding at the beginning of this fiscal year. We now expect the impact of the convert transaction and share repurchases to be accretive to our adjusted EPS this year by $0.13 per share or about 10%, and accretion could reach 20% in the next fiscal year. The combined effect of the reduction of dividends and the shares retired through the buyback will positively impact our cash flow by approximately $30 million this year and $40 million next year.

We continue to prioritize capital investments that support our growth plans and those that will improve our infrastructure to position the company for further growth. In connection with this, we have decided to upgrade our e-commerce platform and implement Salesforce, one of the best global omnichannel platforms available in the marketplace. We believe that the benefits will be significant, and we will be able to impact conversion rates of our global e-commerce business meaningfully. We are currently designing the architecture and sequencing plan for the implementation of the Salesforce platform and plan to roll out the new technology in the Americas and in Europe before the end of next fiscal year.

Another area that we have targeted for improvement has been our inventory management function. I'm very pleased to report that we have made significant progress in just a few months in this area and have been able to reduce our overall investment in inventories to be more aligned with expected sales and to improve the composition and quality of what we own. This has resulted in a meaningful margin improvement this quarter, and we expect further margin benefits in the remainder of the year and into next year as a result of this initiative.

Also, as part of our capital allocation review, we have decided to transition the direct operation of our stores in Australia to one of our key partners. They already have a wholesale presence in the market and a management structure. So the combination will enable us to develop the Guess? brand to its full potential in this market, and ultimately, create incremental value for our shareholders.

The second principle that I have discussed in the past and would like to update you on our progress is regarding product development and distribution optimization. This relates to certain product categories, such as denim, accessories, Marciano and men's just to name a few. We have made progress with our assortments and are very pleased with our Fall and Holiday collections for the respective product lines. For denim, as we mentioned before, we plan to install new denim presentations in 220 stores worldwide, and this will happen during the upcoming September, October months. Regarding Marciano, the North American line is now being fully developed by the regional team based in Los Angeles, and the European collection is being conceived by our European team in Stabio, Switzerland. We are confident that both lines will represent much more effectively the local consumer preferences for each market, and we believe that customer response will be strong.

With respect to our accessories lines and men's products, we have made an effort to design for the 3 specific customer profiles that represent the majority of our business and our growth. I'm referring to our heritage customer and our emerging customer groups, millennials and generation Zs. We also performed some tests during the quarter in a handful of Guess? stores in the U.S. by adopting the assortments, store marketing and visual merchandising to the Gen Z consumers, and the results were encouraging with an improvement in trends of 8% for the test stores over the entire Guess? chain.

The third principle I have talked about in the past relates to our opportunity to pursue global strategies. The main areas that we have focused on in addition to inventory management are logistics and distribution, sourcing and product development, real estate and omnichannel capabilities, which include e-commerce. Other functions already operating with a global focus include finance, strategy, IT and human resources.

For logistics and distribution, we now have one team overseeing the Americas and European businesses. This team is focusing on assessing and optimizing the network in Europe, including productivity improvements through the adoption of some best practices from our more mature North American platform. This is a high priority for us as the cost can and should be significantly reduced here.

Regarding sourcing and product development, we have assigned global oversight to our European leadership team. This team is working with our team in North America, focusing on integrating common development and key fabrics, consolidating vendors and migrating sourcing into lower-cost countries of origin, particularly out of China. I couldn't be more proud with the progress made by this team in the last few months to migrate our production to lower-cost countries and preparing for vendor consolidation. As a result of these efforts, we see meaningful opportunities for IMU improvement.

Regarding omnichannel capabilities, including e-commerce, beyond the implementation of Salesforce, we are looking at several other applications to improve data capturing, customer profiling and segmentation, predictive modeling, personalized marketing and customer relationship management. Last, we have reorganized our real estate teams for all 3 regions and are implementing consistent practices for the function globally, including return models for project approvals and operating and performance requirements.

The fourth principle I discussed relates to our cost structure optimization. As we mentioned during our last call, we have engaged an external consulting firm to help us on this, and we have now completed our assessment of our cost structure in North America and Europe and have identified several opportunities for further efficiencies and cost savings. We plan to implement some of the recommendation as early as Q4 this year and into next year, and expect profitability improvements as a result of such implementations in the short and medium term.

We are also looking at our lease portfolio and see opportunities to reduce occupancy cost over time. We have been able to renegotiate favorable lease terms and are now considering smaller stores to increase store productivity as we improve omnichannel capabilities that allow us to carry a larger assortment online, completely accessible from and through our stores.

The fifth area relates to our customer centricity initiative and our objective to perfect our omnichannel experience worldwide. We continue to focus our efforts in this area and have made it a key part of our strategic business planning work. We see significant opportunities to improve the customer experience across the board and increase the penetration of e-commerce sales over time globally. Our ultimate goal is to offer a seamless customer experience regardless of the channel that the customer chooses to engage with our brand.

Before I turn the call over to Sandeep, I want to focus on 3 big opportunities that I see in the future for our Guess? brands and for our company. First, brand relevancy and attracting a new younger customer. Guess? is truly a global brand with distribution in 100 countries, which represents a significant competitive advantage. Today, only 29% of our business is generated in the U.S. The Guess? brand continues to gain relevancy both with our heritage customer and with the new emerging segments of younger consumers that love our brand. The celebrity partnerships, key collaborations and big experiential events we are driving to connect with those consumers are impacting our engagement and placing Guess? at a different level in our space.

Jennifer Lopez recent tour It's My Party was a resounding success all over the world. She is a global icon, a great performer, at the height of her career and is amazingly relevant with all consumer groups and an incredible ambassador for the Guess? brand in the Latino community and with multiple generations. She now has 99 million followers on Instagram. And one of her posts with the Guess? logo top got 4.5 million likes in only a few hours. We got incredible exposure through her tour with millions of impressions in anticipation during and post every show in 29 cities, where she performed 36 shows during this summer.

Regarding special events, this last weekend, our brand partnerships team, led by Nicolai Marciano, organized an experiential event in LOT 5 at our headquarters campus to launch GUESS Sport, a capsule collection celebrating archival moments rooted in the culture of sports. The activities, including tournaments of basketball, soccer, skateboarding, food and beverage, game for kids, limited especially designed products in collaboration with multiple brands that were available for purchase, music artists performed live and a collection of vintage cars was on display during the event. We believe that these types of events and engagements are very unique and set us apart with that younger consumer that values experiences with authenticity, creativity and originality in a world of sameness. We continue to believe that this emerging customers represent our biggest opportunity for growth both domestically and at a global level. So our focus is in securing partnerships and collaborations that have a global reach augmented by local relationships with strong customer followings.

Second, top line momentum and significant white space to grow globally. As we assess the entire sales network we have in the world as part of our strategic planning efforts, it became very apparent that we still have tremendous white space to grow in multiple markets, and our multi-channel formula offers great opportunities to expand efficiently while optimizing capital utilization. A great example is Europe, where we are experiencing strong momentum across all channels and where several markets are still underdeveloped compared to our brand potential. Also, as we opened many stores in multiple regions in the last few years, a significant part of our fleet is young and store productivity can improve meaningfully before we reach maturity. I see this as a great opportunity to grow revenues without significant additional investments. But the opportunity for global growth for Guess? goes well beyond bricks and mortar and applies to our e-commerce business, which as I have said it before, is very underdeveloped compared to best-in-class companies in our space. As I mentioned earlier, we are in the process of ensuring that we have the right tools and capabilities to deliver a great omnichannel experience.

Third is our operating earnings growth and margin expansion opportunity. The more time I spend with our teams, looking at our current organization and cost structure, our processes and our business performance, the more excited I get about our opportunities to increase productivity, reduce overall costs and increase efficiencies across our model. As we execute on these opportunities and capitalize on the revenue growth potential that we have, we see a clear path for operating margin expansion, which should position us to reach double-digit operating margins.

In closing, I'm very excited about our future, and I'm convinced that we are putting in place a solid plan to tackle our opportunities head on. We have strong talent throughout our organization, and the commitment and passion that you will find in our team is at the top of the chart. I'm thrilled to be in this journey with Paul and our entire team to maximize our purpose as an organization, and I am highly confident in our ability to grow our top line, improve our profitability and create significant value for all stakeholders.

With that, let me turn the call over to Sandeep to review the financials and our outlook. Sandeep?

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Sandeep Reddy, Guess?, Inc. - CFO [3]

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Thank you, Carlos, and good afternoon. During this conference call, our comments reference certain non-GAAP or adjusted measures. Please refer to today's earnings release for GAAP reconciliations or descriptions of such measures.

Second quarter revenues were $683 million, up 6% in U.S. dollars and 9% in constant currency versus the prior year. I would like to highlight that this was our 12th consecutive quarter of revenue growth and is the highest second quarter revenue number in our company's history. Total company gross margin increased 180 basis points to 38.9%, driven by higher IMUs and occupancy leverage. This was on top of a 230 basis points improvement in gross margins in last year's second quarter. Adjusted SG&A as a percentage of sales increased by 50 basis points, primarily driven by higher advertising and corporate expenses. Adjusted operating profit for the second quarter was $48 million, an increase of 30% versus the adjusted operating profit last year and was above our expectations. Adjusted operating margin finished 130 basis points higher than last year at 7%. This was on top of a 130 basis points improvement in adjusted operating margin in last year's second quarter.

I would like to point out that we recorded $6.4 million of nonoperating expenses due to unrealized losses on nonoperating assets and net revaluation losses on foreign currency exposures. This compared to nonoperating income of $1.4 million in the second quarter last year.

Our second quarter adjusted tax rate was 28%, up from 23% last year, driven by the mix of statutory earnings and some discrete items. Adjusted diluted earnings per share finished at $0.38, above the high end of our guidance of $0.30, and included a $0.04 favorable impact from timing of wholesale shipments from the third quarter to the second quarter. Also included in EPS was $0.03 in accretion from the convert transaction and share repurchases, which was more than offset by a negative impact of $0.09 between nonoperating expense and the higher tax rate.

Now, for some more color by segment. Americas Retail revenues for the quarter finished at 1% in U.S. dollars and in constant currency. Comp sales for the quarter, including e-commerce, were up 2% in U.S. dollars and in constant currency, marking our sixth consecutive quarter of positive comps. Positive comps in the quarter were driven by better conversion in UPT. E-commerce had an immaterial impact on comps for the quarter. Americas Retail operating margins in the quarter expanded 20 basis points, marking our eighth consecutive quarter of operating margin expansion. This was achieved through better IMUs and positive comps, partially offset by SG&A deleverage due to wage pressure and higher markdowns.

Staying in the Americas region, I want to take a moment to talk about the Americas Wholesale business. Revenues grew 22% in U.S. dollars and in constant currency and were driven by a continuing strong performance in our U.S. department store and specialty business. The Americas Wholesale operating margins in the quarter expanded 460 basis points, primarily through higher IMU. European revenues for the quarter grew versus last year by 9% in U.S. dollars and 14% in constant currency and were driven by new store openings, growth in wholesale revenue and positive comps. Comps including e-commerce finished down 3% in U.S. dollars and up 1% in constant currency. E-commerce improved the comps for the quarter by 3 percentage points. The comp increase marked the 16th consecutive quarter of constant currency positive comps for the European region.

Our European wholesale business also continues to be very strong. We are currently building the order book for the spring/summer 2020 season and are on track for our sixth consecutive season of double-digit growth. European segment margin improved by 540 basis points due to higher IMUs, lower distribution costs, leverage and lower retail markdowns that drove a 4% improvement in comp gross profit dollars. We now expect lower European logistics cost to contribute at least 125 basis points to margin expansion in Europe for the year. We also expect to be much less promotional than last year during the remainder of the clearance period in the third quarter.

Moving to Asia. Second quarter revenues were up 1% in U.S. dollars and up 5% in constant currency. Comps, including e-commerce, were down 13% in U.S. dollars and down 8% in constant currency. E-commerce improved comps by 1 percentage point. We experienced broad-based weakness in our major markets in Asia, that is Korea, China and Japan, with a weak trend in traffic across all 3 markets in the quarter. Operating margin for the Asia segment contracted 780 basis points in the quarter, primarily due to higher markdowns and expense deleverage as a result of the negative comps.

During the quarter, we closed the transaction to sell our owned and operated stores in Australia to a Australia wholesale distributor. Our guidance for the third quarter and full year revenues for this segment has been updated to reflect the impact of this transaction.

Moving on to the balance sheet. Accounts receivable was $293 million, up 3% in U.S. dollars and 7% in constant currency, in line with our revenue growth. Inventories were $484 million, up 4% in U.S. dollars and 7% in constant currency versus last year. This was another quarter of sequential improvement and was achieved despite accelerated receipts from China into the U.S. during the quarter in anticipation of the impending List 4 tariff increases. We are still carrying some excess inventory from the end of last year and expect to make progress on our plans to move through this inventory through a combination of our own retail outlet stores as well as stock liquidation channels during the balance of the year.

Free cash flow was negative $59 million, an improvement of $9 million versus negative $68 million last year, driven by $11 million lower capital expenditures. This includes a $46 million payment for the EU Commission fine, so our free cash flows improved by $55 million, excluding the impact of the EU Commission fine.

During the quarter, we repurchased 0.7 million shares at a cost of $11 million on the open market. This does not include any shares that may have been bought but not yet delivered under the $170 million ASR we entered into during the first quarter of this year. As a reminder, 5.2 million shares have already been delivered to us against the ASR in the first quarter, with the balance expected to be delivered after completion of the ASR, by the beginning of September.

We ended the quarter with cash and cash equivalents of $131 million compared to last year's $219 million. Cash less debt at the end of the quarter was negative $179 million compared to $179 million last year.

Moving on to the guidance, I should point out that our outlook for the third quarter and full year of fiscal 2020 does not assume any asset impairment charges. However, any potential impact from the List 4 tariff increases is now included in our guidance. Also, guidance for revenues and comp sales for the total company and by segment is included in the supplemental table attached to our earnings release.

For the third quarter of fiscal 2020, we expect revenues for the quarter to be up 4.5% to 5.5% in constant currency. At prevailing exchange rates, we estimate that currency will be roughly a 2.5 percentage point headwind on consolidated revenue growth for the quarter.

Our gross margin is expected to be up primarily due to IMU improvement from our supply chain initiatives. The SG&A rate is expected to be up compared to last year, primarily due to an increased investment in advertising. We are planning an operating margin for the quarter between 3% and 3.5% with a 10 basis points unfavorable impact from currency.

The adjusted earnings per share is planned in the range of $0.15 per share and $0.18 per share, including $0.01 of tailwind due to currency. The earnings per share guidance includes a $0.02 in accretion due to the impact of the convert transaction and share repurchases.

Note that our Q3 EPS guidance includes a $0.04 negative impact from the shift in timing of wholesale shipments from the third quarter to the second quarter. Our adjusted EPS guidance includes an assumption of $1.7 million of cash interest expense and amortization of loan fees related to the convertible debt transaction. Our tax rate for the quarter is estimated to be 30%.

We expect consolidated revenues for the year to be up between 6% and 6.5% in constant currency. At prevailing exchange rates, we estimate currency to have a 3 percentage point negative impact on consolidated revenue growth for the year. For the full year, we expect gross margins to be up due to improved IMUs in both the Americas and Europe as well as lower logistics and distribution costs in Europe. The adjusted SG&A rate is expected to be up for the year due to an increase in investment in advertising as well as performance-based compensation. Our adjusted tax rate for the year is estimated to be 25%.

We are planning an adjusted operating margin between 5.3% and 5.6%, with a 10 basis points negative currency impact on operating margin. And our guidance assumes that foreign currencies will remain roughly at prevailing rates. Adjusted earnings per share is planned in the range of $1.28 and $1.36, with an $0.08 headwind from currency. This includes $0.13 in estimated accretion due to the share repurchases and convert transaction.

Our adjusted EPS guidance includes an assumption of $5.3 million of cash interest and loan amortization expense. As a reminder, our prior guidance for the year was $1.19 to $1.30 with a currency headwind of $0.03. The high end of our new guidance now represents a 39% increase over last year's adjusted EPS. CapEx for the year is expected to range from $63 million to $68 million to support store openings, key store remodels and investments in our technology infrastructure to support long-term growth. This includes incremental investments on the development and rollout of our Salesforce platform that were not contemplated at the beginning of the year. Please note that this is down from $108 million in the prior year.

As I mentioned earlier on the call, excluding the impact of the $46 million EU commission fine, our free cash flow improved over last year by $55 million in the first half. This was driven by improvement in inventory and working capital management in addition to lower capital expenditures. We expect to see a similar improvement in free cash flow in the second half of the year due to continued benefits from working capital management and lower capital expenditures. In addition to this, as Carlos mentioned earlier on the call, our cash outflow for dividends will be lower than last year by approximately $30 million.

In the current quarter, the Board of Directors has approved a quarterly dividend of $0.1125 per share payable to shareholders of record at the close of business on September 11, 2019.

With that, I will conclude the company's remarks and open the call up for your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Susan Anderson from B. Riley FBR.

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Susan Kay Anderson, B. Riley FBR, Inc., Research Division - Analyst [2]

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Nice job on the quarter. Nice to see the continued strong performance. I was curious, you mentioned the higher markdowns in Americas Retail. Curious what was driving that. And I guess, should we expect that also for third quarter? And then also I was wondering on the op margin guidance for the third quarter, why the step down, I guess, year-over-year after the strong second quarter performance? And then it looks like to get to the year more it's baked into the fourth quarter.

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Sandeep Reddy, Guess?, Inc. - CFO [3]

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Susan, it's Sandeep. So I think I'll take your question. There's 2 pieces to it really. I think, the first on Americas Retail. One of the things that I think was very important to note was, if you went through our performance last year, the AUR performance was a big driver of our comp improvement right through the year and especially in the second quarter and right through the second half as well. And that was driven by a very lean inventory position last year as we got into the year. Now this meant that essentially as trends are improving in the marketplace, we potentially lost out and left sales on the table, but we actually had a very, very low markdown rate last year because of that lean inventory level. But this year, as we came into the quarter and came into the year, frankly, we made sure that we had sufficient inventory to fulfill demand. And I think we are now at a more normalized level of markdowns, which is why you're seeing a slight pressure on AUR that was actually there in the quarter. The similar dynamic was expected to last into Q3 as well. But I think, again, we feel pretty good about the inventory that we're carrying and about the cadence of the business. We don't feel it's to do over clearing of inventory, and the margins are very healthy that we're experiencing on the Americas business.

And I think, on the second question that you had, Susan, you were talking about the op margin guide, and I think we're talking about 3% to 3.5% compared to 3.7% last year. The important point to note is that we experienced $0.04 worth of timing benefit in the second quarter because the timing of wholesale shipments shifting from the third quarter into the second quarter. And if you actually take such timing and put it back into the third quarter, our margins would have been expanding in the third quarter at least from the high end. So I think, that's an important dynamic to take into consideration when you're looking at the third quarter by itself. But we feel really good about the performance of the company so far in the year and on a full year basis. So when you look at the full year guidance, we're now raising the full year guidance to 5.3% to 5.6%, which is a pretty material improvement in guidance, especially because we lost 10 basis points in currency. And I think we feel really comfortable that the business is going in the right direction and that's reflected in our guidance.

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Susan Kay Anderson, B. Riley FBR, Inc., Research Division - Analyst [4]

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Great. That's really helpful. If I could ask maybe one follow-up on Asia. It looks like from your third quarter guide, maybe you're seeing some improvement there. I don't know if there's any color you could give on just third quarter to date so far in China if you've seen some of the pressure against this -- or if you're seeing that weakness kind of get a little bit better?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [5]

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Yes. Susan, this is Carlos. Let me take that. Asia is, obviously, a big opportunity for us, but also we are seeing some softness just to make a little bit of history. I think we talked about this during the last call. But let me address this in kind of, like, 3 different pieces. The first one is about the environment in Asia. The second one is what we are doing about it. And then let me talk a little bit about what this means for the long term for our business there and the opportunity.

So let me start with the environment. We saw a very sudden change in the trends at the beginning of the year. This was right after the Chinese New Year. And the big sudden change was primarily driven by lower weak customer traffic into our stores. And this happened in the 3 major Asian markets that we have. So it wasn't just China, but also in Korea and Japan. We believe that this is not specific to our brand in any one of those markets, and we believe that this more of a macro type of issue. The key performance indicators that we follow very intensely into our stores show that the customer is still responding when they are in the store. So all the key things, such as conversion rates or units per transaction or average order value, all those metrics seem very consistent with what we saw in the past. And then we saw that when we went with public sales to just drive additional traffic to clear product, and this is completely customary during those times, we didn't see that the traffic was coming into the stores. We also understand that many companies that operate in the same space are experiencing the same type of customer trends. So we know that this is not just about us. And we know that there is weak traffic even into department stores, especially in Korea and Japan, that we know for a fact. So you put all this together, and we say, okay, definitely not us. However, what can we do to really improve our business? We -- I visited China and met with the team there a few weeks ago, and I had a big opportunity to spend time with the team, and we have a great team. We saw significant opportunities. First of all, I was completely amazed with the -- how vibrant our Guess? brand is in China, and I saw this with my own eyes there. It's just exciting. There is -- this a very young customer, a lot of excitement in the stores. Many customers are trying clothes on. They are sharing with others a lot of social interaction in the stores and tremendous energy, which is very inspiring. And then I saw big opportunity on the product. We are working on styling, prints, sizing, fits. They're all issues that are very much more specific to the markets. And right now, we don't have specific product for those markets, but we think that we can really develop with much more accuracy the type of product that, that customer will respond to, including speed-to-market opportunities and initiatives.

We are also revisiting the entire customer experience. We think that this could include, in addition to all the technological issues and opportunities that we have that we currently don't have, omnichannel and digital capabilities are part of that. But also including the layout of the store, we don't have as many fitting rooms as you would expect considering the kind of activities that we're seeing. So there are a lot of things that we can do to really improve that experience while the customer is in the store. And even loyalty membership, which is a big opportunity for us. We are seeing great response when we offer customers to join this membership, and we believe that there is an opportunity here to also integrate data analysis with what we do online.

Last, but not least, we think that there is a lot we can do on marketing. And in fact, the team is working very hard to coordinate with our brand partnerships team here to bring some of the relationships that we have into their markets and even going into those markets with groups that could be very much more local and having a much more impact at the local level. So in September and October, for example, we are doing a collaboration with 88Rising, which is a group that -- the relationship was born here with Nicolai's team. And this group is going to send -- they're going to perform, they're going to have big events. We're going to be represented in Hong Kong, Macao, Taiwan and then we're going to China in October and November prior to their tour in Chengdu, and the group that is going to perform there is called Higher Brothers. And there was going to be a tour from them and they are from there. So very exciting that.

And then last thing I would say is about the teams. We have people that have been doing this for a very long time. We have tremendous expertise in the markets, and I feel that we have an incredible team and this applies to all those major markets that I mentioned, in addition to the tenure, I think, that there is tremendous expertise in those markets to really lead us in the right direction. So what does all this mean? Just we keep looking at the Asia business. Obviously, this represents a big opportunity for us as a company long term, and that long-term potential does not change in our eyes. We have a good base of stores in China, for example. We have about 200 doors right now. We have more space to grow in Tier 3 and Tier 4 cities. But because of our business model, we have the opportunity to work with potential franchisees, so then we can minimize the capital deployment and still we can develop the brand really quickly. So -- in the meantime, of course, we're going to be very careful. We are reassessing our investment plans, and we plan to make capital decisions that are based on true trends and the potential that we see. So overall, just -- I think that, yes, we are going through a little bit of a softness here with the business. But when you look at the overall potential and how the brand is positioned over there, I think that we have an incredible opportunity here that for now we're going to absolutely support every single day.

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Operator [6]

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Next question comes from Janine Stichter from Jefferies.

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Janine M. Stichter, Jefferies LLC, Research Division - Equity Associate [7]

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Nice to see the progress. Question on the inventory. So can you help us just think about where ended the quarter versus may be where you're expecting? It feels like it ended maybe a little bit better than we would have expected. And then just on parameters on how much more you feel like you have to move through and maybe kind of how that breaks down regionally?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [8]

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Let me just start here. I'm sure that Sandeep will have comments to add. But yes, we put a really aggressive plan for the inventories to be monitored and managed very effectively. And I am just so happy with how the team has embraced this initiative. And this is a big company, a complex company. I have been back in the company now for 7 months, and I'm incredibly proud and amazed on how much we are accomplishing, and this is not my -- to my credit, but the team. Really it's just an incredible energy that is coming through. So with inventories, we looked at the inventory position that we had. And I think we may have said in the past that there were 2 big things that we needed to do. One was to address what we owned at that time and there was a lot of, in the composition of the inventory, that was not desirable. So we had to really find a way to really make all that inventory just to be liquidated, and we put plans in place. And even Sandeep mentioned today that we still have some residual from that and we have a plan for it.

The second big thing, and I think that this is probably even more just critical is to make sure that we don't replicate, we don't duplicate that -- those same mistakes, just -- and it's more about how we plan and how we buy as opposed to what we own. And so we are putting a lot of emphasis on the -- those processes and making sure that we never buy more than what we think we can sell at healthy margins, because this has an impact not only on the liquidation and margins performance, but also on the brand, and that is the most important thing to us. So we are in that process. We are very happy with the progress that we have made so far. You're absolutely right, we ended the second quarter in a better place than what we originally thought. And frankly, we are now anticipating that we may end this year in a better place that we originally thought as well. And we are just looking at this every single day. It's the only way to do it well, being obsessed about it.

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Sandeep Reddy, Guess?, Inc. - CFO [9]

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And I think, just to add, you asked for some regional color. When we came into the year, we talked about Europe and Asia being the more challenged regions in terms of inventory levels as well as composition. And I think what's really been very encouraging is in Europe, we made a lot of progress in the first 6 months, and that's been a big driver of the performance of inventory so far in the first half. And I think we still have more work to do in Asia, especially because sales trends have decelerated compared to where we thought they were going to be at the beginning of the year. And so that's work that we will be doing in the back half of the year to get that under -- into a better place by the end of the year. And I think on Americas business, like I mentioned earlier in my answer to Susan, we feel pretty good about where our inventories are. So I think overall when you think about the different regions that gives you some color for where things are at.

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Janine M. Stichter, Jefferies LLC, Research Division - Equity Associate [10]

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That's very helpful. And then just one quick follow-up on the Americas Wholesale piece, I know you said there was the $0.04 timing shift, but excluding that, can you give us a sense of where the growth is coming from in terms of how much is traditional department stores versus some of the newer specialty accounts that you've gotten into over the last couple of years?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [11]

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So Janine, the first clarification, the $0.04 is not just Americas Wholesale, but it also includes European wholesale. So we had early shipments in both businesses. And with respect to Americas, just I -- this is another wonderful thing coming back into the company, seeing the relevancy that the brand has today, we are seeing a pretty significant traction with retailers, partners, such as Urban Outfitters, Pacific Sunwear. These are retailers that do very well with younger consumer, and that has fueled some of our health and strength in the wholesale business. And in addition to that, we have had very good business with other partners that are more traditional, meaning like Macy's, which -- for whom our business is very healthy and very strong and growing. So we are very pleased with our wholesale business, not only top line, but also the profitability. It's also pretty much in line with our expectations because we are seeing that the sell-throughs of this product is very healthy as well. So, obviously, this has a major impact on margins and our IMUs are up.

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Operator [12]

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Our next question comes from John Kernan from Cowen and Company.

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John David Kernan, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [13]

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Congrats on outperforming all of your peers across retail both in North America and Europe this quarter. Carlos, your confidence sounds increased this quarter over last. And it sounds like you're excited not only on the top line, but also on the cost structure and margin structure, and you talked about the (inaudible) efficiencies that you may see start to play out next year and beyond. Can you just talk to us, since you arrived and rejoined the company, what you've learned and where you see the most -- the biggest opportunity for margin expansion going forward? And then Sandeep, I have a couple of follow-up questions for you as well.

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Sandeep Reddy, Guess?, Inc. - CFO [14]

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Sure.

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [15]

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Yes. Thank you, John. I think that if you think about the typical P&L, there are 3 big things that can drive operating margin, right? And at the top, I think is definitely revenues. This company continues to grow in spite of the fact that we have a very sizable business. But I think that the big opportunity here is to continue to penetrate the world, and that's -- those are big words, but Guess? has done it time and time, again. So $2.7 billion business, I have talked about $5 billion brand and with opportunities to continue to grow, and we see that as we did a lot of the detailed work and looking at different countries, penetration and opportunities to continue to grow, we see a lot of white space. So that is first. And obviously, if we can get top line growth, just finding leverage and to expand operating margins, I think, it's a very -- much more doable thing to do.

The second big thing is about margins. Gross margins, I'm talking about. And I think that the team has done a great job on IMU growth. And you would think, okay, well, now we're done with that, what we do next? But I think that there's still a lot of opportunity in IMU, lower cost of origin and the migration from China out, going into lower-labor markets. I think that there is a lot of opportunity in fabric platforming, but also using common fabrics across the different designs that we have. We see a lot of opportunities in other accessory costs within the makeup of the product. And then organizationally, I think that we can do a lot of things more efficiently. Right now, we have 3 different teams and in different regions doing very similar things. We have vendor bases that are not completely integrated. So there is a lot that we can do in this whole world and the great thing is that we're already on it. We have a team that is driving this in a very aggressive and progressive way.

In addition to that, you look at how we are managing inventories and doing allocations and making sure that we are effective with the use of the product that we buy. And we see a lot of opportunities, part of the efficiencies that we identified with the use of these consultants that we work with, is about this whole world. And this would require a new way of thinking and also would require some additional tools, and we are looking at what kind of tools to implement, to be able to go after that opportunity. So -- and this should result in lower markdowns and lower out-of-stock situations so then we can maximize sales as well.

And then if you look inside the P&L, and you go into the cost structure, there are a lot of opportunities, starting with how we run stores and how we allocate labor hours to meet customer demands and enhance conversion rates. There are things across the logistics and distribution area that, obviously, we had some issues in Europe last year. We are on that and looking for how to optimize that whole area. But there are many opportunities in the whole world of logistics and distribution in addition to that one particular transition that I'm referring to. There are big opportunities inside the whole corporate structure, and we are looking at that as well. And when you put it all together, we see that we could be looking at a double-digit operating margin, and we see that nothing has to change dramatically to be able to get there.

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John David Kernan, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [16]

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Got it. Looking forward to October when you give us some more detail. Sandeep, I know you lapsed some onetime-type disruption in logistics in Europe in the first half of this year, and certainly the margin recovery was quite impressive. Just wondering how we should think about European profitability as we go into the back half of the year.

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Sandeep Reddy, Guess?, Inc. - CFO [17]

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Yes. And I think that's a great question, John. And I think one thing that we'll -- actually have picked up on the European margins in this particular quarter was for the first time, and I'd say, I think probably 8 quarters now, we actually saw the logistics cost being a tailwind to margins. And it's going in the right direction. But we've said that from the beginning of the year that we expect and now we've updated to say 125 basis points of margin expansion just from the logistics costs alone this year. But if you look at the halfway point here, we're up about 440 basis points in margins already, with the tailwind only starting in this quarter. So there's more going on beyond just the logistics cost. The IMU improvement is definitely helping. We were a lot less promotional during the second quarter in our retail stores because we got ourselves into a good position with inventories, and we were able to drive comp gross profit dollars. And we expect to see more of the same as we go into the third quarter and the rest of the year. And when the sales are growing at the rate at which they're growing, we're seeing leverage and we expect to see more leverage as we go through the year. So we're very excited about where margins are going in the European business. And we see very good potential to recover a lot of the margin that we lost last year through all the drivers I just mentioned this year.

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John David Kernan, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [18]

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That's really helpful. And then final question just on inventory. It sounds like you guys are confident in terms of the direction and where it's going and how you're buying, and just on your top line environments. So just wondering should inventory be relatively in line with sales just as we try to model the free cash flow at the end of the year.

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Sandeep Reddy, Guess?, Inc. - CFO [19]

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Yes. I think what you see already by the second quarter, John, is that inventories and sales are relatively aligned already. But we see more potential to do better in the back half of the year because as we move towards the back half, we were carrying too much of inventory last year. So we should actually see potentially an outpacing in terms of where dollars and inventory are relative to sales growth, and inventory should actually be lower than the prior year as we go through the back half.

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [20]

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And just I would add there that one thing that we are doing is, we are not just looking at last year's inventories and trying to be just lower than that, we are trying to forget about what the company owned in the past and say what would be ideal to own in the future. And that's the way we are managing inventories. So you may see that the reduction in inventories is much more than what you would expect based on the sales trends, because it could be that the company was carrying excess inventories that was not completely necessary to produce the sales that it was producing.

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Operator [21]

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Our next question comes from Omar Saad from Evercore ISI.

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Westcott Irvin Rochette, Evercore ISI Institutional Equities, Research Division - Associate [22]

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This is Westcott on for Omar. I wanted to dig in a little bit deeper on the Gen Z customer, the store testing you're doing, how you will continue to kind of recheck customer. I know you already mentioned strong reception in PSUN and Urban. I've also noticed in Foot Locker for the first time, which is something I wouldn't have thought in the years ago. But as you think about continuing to reach that customer, how do you incorporate it into the store environment that you have? Or do you plan on rolling out, like more specific-aligned stores for that customer?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [23]

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Yes. It's a good question. And frankly, we continue to study this particular topic. For now, we are thinking about the 3 big groups of customers or profiles that we are having good rapport with and response from. And one of those customers is this Gen Z customer. Definitely, the efforts on the marketing side that brand partnerships team is driving have really created this opportunity for us. And what we are doing now is looking at how we can participate in that lifestyle of that customer and developing product for them, for the occasions that, that customer may participate in. And some of this is being done through the brand partnerships group.

Now when it comes to the test, we have done -- just we took the product that was already available. So it's not that we went there, and we said, okay, let's go and design completely new products for this test. We took the product that was available, but that was more propense or more in line with what that customer is looking for. And then we changed the visual presentations. We gave more space to this type of product and to get away from some of the other product, and changed the whole marketing outside, with visuals and images. And the results were very compelling. It's only a limited number of stores that we're talking about. And the stores were selected based on the penetration of this type of product for previous sales. So obviously, we are going after those areas where we think that there is an alignment with this customer. That being said, just the key thing here is not different whether we are talking about the generation Z customer or the heritage customer or the millennial customer, because it's all about capturing data, then taking all that data and analyzing it, and doing segmentation and trying to really understand how this customer shop and how they behave, what type of activities they participate in and then doing personalized marketing and personalized product, if we think that, that is necessary. In this case, we believe that, that is necessary because it takes and the lifestyles are very different than from that other heritage customer, for example. So as a result, we are preparing our line plans, meaning, saying, okay, what we do we want in the line? And when we do that, we are allocating a portion of that assortment to be specifically designed for this type of customer. And that includes what the brand partnerships team is doing in addition to what our core designers are doing as well.

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Westcott Irvin Rochette, Evercore ISI Institutional Equities, Research Division - Associate [24]

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Awesome. That sounds really great. And -- so something seemingly very big and new today is the rolling out of your new e-commerce platform, the CRM. As you kind of think about that, one, can you tell what your penetration is today? And two, where you think the main focus points are to improve the app conversion? Is it to back-end inventory and to your line? Where do you think you can leverage e-commerce that you haven't to date?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [25]

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Yes, sure. Yes, so starting with penetration. I think we have said in the past that our penetration is about 12% of our direct-to-consumer sales. So -- and this is a global number. It's very low. If you think about companies that are best in class here, we are looking at numbers between 30% and 40%. Now it's not an apples-on-apples comparison because we know we are a brand that has licensees, we have a very significant wholesale business, so it's not that you can compare us to a vertically integrated retailer until -- when it comes to this penetration. But that being said, we know that there is a tremendous opportunity for me -- for us. So we started looking at the tools that we had, and our e-commerce platform is one that is completely designed and maintained in-house. And when we look at other opportunities outside, we saw that Salesforce is definitely among the best in the market today and it offers things such as a platform that is built for performance. You have a much faster response time. We can improve our search algorithms and be significantly more effective with search. They have artificial intelligence recommendations that today we don't have access to. They can do customer group segmentation and personalization, which today has to be sitting on top of our infrastructure to be able to do anything like that. We can improve our visual merchandising, complete control over all the price books that we use to run the business. So there are a lot of things. But probably the most significant one that is going to drive money to the bottom line is an increased conversion rate.

We have a pretty significant cart abandonment rate today that can be completely just improved. And when we compare -- even if I hadn't told you any of this, when we compare our conversion rates to the industry, we know that we're trending at about half of what -- where the industry is. So imagine what that means. With the same traffic, we could be doing double the business that we're doing today. So we know that this is an incredible investment for us. It's going to take us some time, but we feel that we have a great team that is driving it. We are going to be just looking at what this architecture will look like because we don't just want to convert one brand or one territory. We want to go after the entire world over time. Initially, we're starting with both Europe and the Americas, and we want to be done before the end of next year.

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Westcott Irvin Rochette, Evercore ISI Institutional Equities, Research Division - Associate [26]

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Okay. And just one question on that is, the investment that's in it will be both the capital and I'm sure some margin. Is that going to impact the cadence of your margin improvement as you make those investments thinking over the next 1.5, 2 years?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [27]

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Yes. No, it's a great question. So with respect to the capital that is going to be required to implement the application and the platform, it's the -- our necessary capital for this year is already included in our guidance. I think we took the upper end of CapEx to $68 million and that is up from $65 million before. This doesn't imply that we're going to spend $3 million. The number is a little bit higher than that, but we were able to find some opportunities to cut some of the other capital requirements for this year. So we are comfortable with this $68 million max for this year. There is more capital that is going to hit next year and it's about of the same type of size and magnitude. That being said, yes, there's going to be some impact on the cost structure and an ongoing basis is the way this -- the compensation for Salesforce works. But we have done the numbers in multiple ways and the return on this is kind of insane if you believe some of the conversion rate growth that we can see.

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Operator [28]

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Our next question comes from Dana Telsey from Telsey Advisory Group.

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Dana Lauren Telsey, Telsey Advisory Group LLC - CEO & Chief Research Officer [29]

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It seems like, obviously, you've made some nice changes, and you're doing a lot of testing, whether it's the test stores that you have with the Gen Z customer where those stores were up around 8%, what you're doing with the denim in order to enhance denim with new denim presentations. Where are you on these tests? Are they globally that you're doing these tests? What's the cost of these tests? And how quickly do you see them rolling out?

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [30]

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Yes. So far the tests are not very costly. If you think about the Gen Z test, that was just using everything we had, including product, including images and so forth. So the costs were very insignificant. When it comes to denim, frankly, we didn't take this as a test. We know who we are. We are a denim company at heart. And denim, frankly, as a category was not respected or presented in the way that you would expect to be presented to continue to be a dominant company and brand in that category. So all we are doing is, kind of, like, bringing that presentation back into the stores. We used to have them and now we want them back. So we are going to hit about 220 stores. This is global to your -- just talking about your question. And we feel that this is just the beginning. We're going to do more as we get close to the next season and so forth. But overall, it's just giving a great presentation to a category that we know is a very, very critical category for us and is strategic to not only bring the customer in, but also to enhance the whole experience and increase total units per transaction and sale. So we are very excited about this. The total cost is included in our capital for this year, and it's not a big number, but we're talking about a few hundred thousand dollars to be able to do the 200 stores that we are -- or 220 stores that we are introducing now.

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Dana Lauren Telsey, Telsey Advisory Group LLC - CEO & Chief Research Officer [31]

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Got it. And denim, how do you see the growth of denim? How do you see the Fall and Holiday? And it seems like the order book remains strong in Europe.

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [32]

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Yes. We are seeing some early signs that are encouraging on denim, but it's too early. The installations are not even out. We only have a couple of stores that we did test initially just to see how we felt about the presentation. But this is going to happen in -- towards the end of September and October. And we have done a lot of work on the assortment of denim, and we are very excited, and we'll see how things work. There are a lot of new things in denim that we feel that we didn't have in the assortment that now we will have, and it's an exciting time for us. And this applies to both women and men.

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Operator [33]

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We have no further questions in queue. At this time, I will turn the call back to Carlos for closing remarks.

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Carlos E. Alberini, Guess?, Inc. - CEO & Director [34]

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Yes. Thank you, operator. I just want to say thank you to all of you for participating today. We had a terrific second quarter, that's the way we feel here. We had great results in spite of the softness that we are experiencing in Asia. Our business in Europe continues to thrive in all channels, and our Americas business continues to gain momentum and grow profitability. So we feel very, very good about our business. We still have big opportunities for our company to grow operating margins over time, and those are all in front of us, but we feel that we are putting together a great plan and we have a good team to be able to go and attack them. And I couldn't be more excited to continue to report on our progress, to be honest with you. So we hope to see you in October for our Analyst Day. And again, thank you for participating. Have a great day.

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Operator [35]

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Thank you. Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect.